These bonds have a maturity of three years with an interest rate of 5% per annum that is payable annually. It’s a monetary figure reflected by the amount paid in addition to the fair market https://personal-accounting.org/ value of a company when that company is purchased. Goodwill usually isn’t amortized (except by private companies in some circumstances) because its useful life is indeterminate.
The corporation decides to sell the 9% bond rather than changing the bond documents to the market interest rate. Since the corporation is selling its 9% bond in a bond market which is demanding 10%, the corporation will receive less than the bond’s face amount. The company usually issues the bond at a discount when the market rate of interest is higher than the contractual interest rate of the bond. After all, investors are unlikely to pay for the bonds at the face value if they can invest in other securities with similar risks but providing a better rate of return. To illustrate the discount on bonds payable, let’s assume that in early December 2021 a corporation prepares a 9% $100,000 bond dated January 1, 2022.
- Since bondholders are holding higher-interest paying bonds, they require a premium as compensation in the market.
- When an issuer elects to use this option, no unamortized discount exists because the discount was written off at once.
- Unamortized Bond Discount refers to the portion of a bond’s initial discount that has not yet been amortized or allocated over the bond’s life.
- This account recognizes the remaining amount of bond premium that the bond issuer has not yet amortized or charged off to interest expense over the life of the bond.
Bond issuers who receive higher credit ratings are far likelier to fetch higher prices for their bonds than similar, lower-rated issuers. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. Founded in 1993, The Motley Fool is a financial services company dedicated to making the world smarter, happier, and richer. The Motley Fool reaches millions of people every month through our premium investing solutions, free guidance and market analysis on Fool.com, top-rated podcasts, and non-profit The Motley Fool Foundation. The journal entries for the remaining years will be similar if all of the bonds remain outstanding.
Example: Unamortized Bond Premium Calculation
Likewise, the company will make the journal entry to account for the bond discount by debiting the amount of the difference between the face value of a bond and its selling price in the unamortized bond discount account. The bonds have a term of five years, so that is the period over which ABC must amortize the discount. For example, if a company issues a 5-year bond with a face value of $1,000 at an issuance price of $950, it has an initial bond discount of $50. Over the five years, this $50 discount will be amortized as additional interest expense. If, after the first year, $10 of the discount has been amortized, the unamortized bond discount would be $40 ($50 initial discount – $10 amortized).
The preferred method for amortizing the bond discount is the effective interest rate method or the effective interest method. Under the effective interest rate method the amount of interest expense in a given accounting period will correlate with the amount of a bond’s book value at the beginning of the accounting period. This means that as a bond’s book value increases, the amount of interest expense will increase.
Recordkeeping for Discount Amortizations
The interest payments of $4,500 ($100,000 x 9% x 6/12) will be required on each June 30 and December 31 until the bond matures on December 31, 2026. In the next section, you’ll see an example of the calculation using the straight-line amortization method. Ultimately, the unamortized portion of the bond’s discount or premium is either subtracted from or added to the bond’s face value to arrive at carrying value. Based on the discounted future cash flows of the $300,000 bonds that have been issued, the effective interest rate can be calculated to be 6.9018% per annum. For example, on February 1, the company ABC issues a $100,000 bond with a five-year period at a discount which it sells for $97,000 only.
“I’ve Gotta Get This Done, or Else”: How Mitch Passed His CPA Exams
Buying below par enables investors to increase their effective return on investment on the interest the bond issuer pays. Because the issuer sold the bond for less than its face value, the issuer must reflect this discount on its balance sheet. The premium or discount is to be amortized to interest expense over the life of the bonds. Hence, the balance in the premium or discount account is the unamortized balance. The amortization of bond discount can be done with the straight-line method or the effective interest rate method depending on if the amount of discount is material or not. If the discounted amount is material the company need to amortize the bond discount with the effective interest rate method as it is a more accurate method compared to the straight-line method.
Companies try to issue bonds for the amounts shown on the face of their bonds. However, in periods of fluctuating interest rates, this is not always possible. When a company does not immediately expense the discount, unamortized discounts arise with respect to those bonds. Suppose ABC Corporation issues a 3-year, $1,000 face value bond with a stated annual interest rate of 5%. Because the bond’s interest rate is less attractive than the market rate, investors would be unwilling to pay the full face value for the bond.
Any amount that has yet to be expensed is referred to as the unamortized bond discount. The discount alludes to the difference in the cost to purchase a bond (its market price) and its par, or face, value. The responsible company can decide to expense the whole amount of the discount or can handle the discount as an asset to be amortized. Any amount that presently can’t seem to be expensed is alluded to as the unamortized bond discount.
This figure is utilized by companies and investors to accurately calculate the book value of a bond and to determine the company’s financial position, enabling a proper reflection of the bond liability on the balance sheet. As the bond discount is gradually amortized, it increases interest expenses, thus affecting the company’s financial performance and tax liabilities. Consequently, understanding and monitoring the Unamortized Bond Discount is crucial for making informed financial decisions, optimizing a company’s funding strategy, and ensuring compliance with accounting standards.
Discount amortizations are likely to be reviewed by a company’s auditors, and so should be carefully documented. Auditors prefer that a company use the effective interest method to amortize the discount on bonds payable, given its higher level of precision. The second way to amortize the discount is with the effective interest method. This method is a more accurate amortization technique, but also calls for a more complicated calculation, since the amount charged to expense changes in each accounting period.
Instead, they sell at a premium or at a discount to par value, depending on the difference between current interest rates and the stated interest rate for the bond on the issue date. On an issuers balance sheet, this item is recorded in a special account called the Unamortized Bond Premium Account. This account recognizes the remaining amount of bond premium that the bond issuer has not yet amortized or charged off to interest expense over the life of the bond. An unamortized bond discount is reported within a contra liability account in the balance sheet of the issuing entity. Bond prices move up and down constantly, and it’s common for bond investors to face situations where they have to pay more than the face value of a high-interest bond in order to persuade the current owner to sell it.